Recession in 2007?

Do you have a net worth of $1 million? Own a hedge fund? If the answer to one of those questions is "yes," then chances are that you know John Mauldin -- president of Millennium Wave Advisors, author of the weekly e-letter " Thoughts from the Frontline," and perhaps the leading proponent of the theory that America is in the midst of what he calls a secular bear market. When you need a big-picture view of what's going on in the economy, John Mauldin is the guy to ask. Fool contributor Rich Smith did just that. (Click here for part 1.)

Rich: Let's discuss another of your favorite subjects: the yield curve. What is it, and why is it important?

John: Basically, it's the difference between short-term and long-term interest rates. Fair value for short-term debt is typically 2% to 3% above the rate of inflation. And long-term debt would ordinarily command an even greater return. When long-term rates become lower than short-term rates, however, that's when we say the yield curve has become "inverted."

As for why it's important, there comes a time when the Fed has raised short-term rates too high. If inflation is 3%, and the Fed raises rates much higher than 5%, for example, then things start looking dangerous. And if at the same time as this happens, long-term rates are below short-term rates, then things can get really interesting.

My view is that the Fed is going to continue to raise rates until it sees results that affect the housing market. Specifically, the Fed is targeting the price of your home -- they want it to stop going up. That's going to hurt homeowners, of course, but the Fed is mainly concerned with preventing inflation in the future. They're willing to inflict some pain today to save even more pain in the future.

Historically, the Fed has a tendency to raise rates more than most people think it will and to keep raising rates until they see the economy slow down. Personally, I won't be surprised to see the Fed go to 5.5%, despite the release of the Fed minutes that many interpret as "dovish" on interest rates. If we see two to three months of prices declining in the housing market, then that would tell me the Fed might stop at 5.5%. On the other hand, if the economy is still booming and the housing market is still rising, I think they will go past 5.5%.

Rich: When the yield curve first inverted a few months ago, the financial press did the literary equivalent of rending hair and donning sackcloth. Since then, the stock market hasn't fallen, the world hasn't ended, and barring the occasional article, we hear very little about the inversion phenomenon anymore. Thoughts?

John: Well, remember that the yield curve only stayed inverted for a few weeks or so and was only inverted by a few basis points. What we saw in January was a "baby" inversion, but the yield curve is only a good predictor of recession when the inversion is of a significant size -- say 10 to 20 basis points or more -- and if it remains inverted for 90 days or more.

So that's the good news. If we're going to see a recession, it won't be until 2007, because the inversion didn't stick. The bad news is that, with long-term rates beginning to rise again, the Fed now has room to continue raising short-term rates if it wants to -- and that could still slow the economy, even if we don't fall into a full-blown recession. That said, nothing in the yield curve today tells me that it's now time to pull your cash out of the market.

Rich: The Fool's own resident sage on things financial and arcane, Bill Mann, wrote a column on this back in January. Where did Bill go wrong? Where is he right?

John: He's mostly right. But foreign banks have purchased mostly shorter-term paper, so they are not that big a factor in 10-year rates, although foreign individuals are. Further, while an inverted yield curve is not causative, it is indicative of a situation where the normal expectations of return are out of sync. And this is what we should be paying attention to.

Rich: Your latest book, Just One Thing, is a great read. But one chapter in particular stood out: Bill Bonner's laissez-faire rant in Chapter 7. What was he trying to get at there?

John: Bill is a libertarian. He's also a very successful businessman. While most of the book is devoted to my friends and colleagues giving their best investment advice, this chapter was what Bill wanted to say, and we both agreed it had a place in the book. Speaking of which, I think that's a real strength of Just One Thing -- there's something in it for everyone. And although it may not have a real practical application to investing, many people have written me to say that Bill's was their favorite chapter in the book.

Others liked Andy Kessler's chapter, for instance. He offers some great insight into using the concept of scalability to find tech companies that can really profit as a market expands. If you remember, Andy was the hedge fund manager who turned $100 million into $1 billion during the bubble and then got out at the top. You don't accomplish something like that by luck. Speaking of Andy, I should probably mention that he's working on a new book of his own, due out in June, called The End of Medicine, where he looks at the concept of scalability among medical companies. It will be his fourth book, and I think it is his best. It will be worth a read.

Stay tuned for part 3 of Rich's talk with John Mauldin. ( Part 1 is here.)

Fool contributor Rich Smith doesn't give a darn about the yield curve. He's too busy worrying about long-term rates and how much it'll cost for the second mortgage he'll need to afford the Sony PlayStation 3. The Motley Fool has a disclosure policy.

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